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National Institute of Economic and Social Research

Wednesday, 11 April 2012

The European Commission is doing its best to drive Spain to disaster

[Updated 11 April 2012 with this preface]Unfortunately, the Spanish government has largely failed to take the advice set out below. Instead, it is pressing ahead with an additional budget cuts of 10 bn euros. This has, predictably, been welcomed by the European economic policy establishment; ECB Council Member Ewald Nowotny said:

“The Spanish government is taking the necessary steps which will contribute to help calm the markets”.

Equally predictably, this is proving to be complete nonsense; markets are not stupid. As the FT says here:

"Investors fear that tough new austerity and economic reform programmes in Spain and Italy could hold back growth, undermining the ability of these countries to reduce debt levels. "

The original article from El Pais, 29 March 2012, co-authored with Ana Rincon-Aznar, also of NIESR, is here. Here is the English version:

Rajoy has to be more prudent than Cameron

The economic policies of the European Commission of the last two years have been mistaken. The objective of reducing Spain's deficit by 4% of GDP is absurd and unrealistic.

Just after the last UK election, Sr. Rajoy told El Pais "El plan de Cameron da confianza; yo haría algo similar en España". [The Cameron plan has given confidence; I will do something similar in Spain]. In doing so he was following the fleeting intellectual fashion of the time, that somehow accelerated fiscal consolidation would restore “confidence” and hence growth.

Fortunately for Sr Rajoy, however, the Spanish election was a year after ours; so he has had a chance to see the reality, both in Spain and in the UK. As I pointed out, again in these columns, last summer, the Cameron plan led to a fall in business and consumer confidence. According to the plan that Sr Rajoy praised, the UK should by now be growing at close to 3 per cent. In fact, growth was negative in the last quarter , and recovery is likely to continue to be slow.

Now now Sr Rajoy faces a turning point. He can follow the example of Prime Minister Cameron, and cut spending aggressively in order to “restore market confidence” – and, in Spain’s case, meet the economically illiterate demands of the European Commission. Or, he can proceed in a more prudent manner, and focus his main policy effort on dealing with Spain’s real problem; how to reduce unemployment and restore growth

To understand why the latter is correct, it is important to understand why Spain is in its current position . Previous Spanish governments, of both parties, made two big policy mistakes. The first was to allow massive private sector credit expansion, financed in large part from external capital flows, and channelled into a housing bubble. And the second was to allow the entrenchment of a two-tier labour market, where the employment rights of “insiders” – who are older, better paid, and more likely to be members of trade unions - are far too generous, while “outsiders” – younger, poorer, more likely to be female and to be of immigrant origin – can be hired and fired at will. The interaction of these two led to a sharp rise in growth – driven largely by construction – and employment, almost all represented by “outsider” workers on temporary contracts, but without the necessary rise in productivity.

When the financial crisis hit, this apparent synergy became a downward spiral. As house prices fell and the credit bubble deflated, the private sector switched sharply from borrowing to saving. Construction ground to a halt., consumer demand fell and businesses fired the people they could easily fire – young people on temporary contracts. We know the results – a deep recession and youth unemployment at 50%.

What role did fiscal irresponsibility play in this? Almost none, because, despite the serious policy errors just mentioned, Spanish fiscal policy was generally prudent; in 2007, on the eve of the crisis, the IMF estimated that Spain had a substantial structural surplus. As Martin Wolf put it in the Financial Times, Spain’s fiscal difficulties are a consequence of the crisis, not a cause; the deficit is simply the mirror image of the private sector’s swing from borrowing to saving.

In such conditions cutting the deficit too fast simply makes matters worse, as we have known since the 1930s. It reduces demand further; the private sector, quite rationally, responds by investing less and reducing output and employment, since demand is falling. This is the vicious spiral already afflicting Greece.

So what should Sr Rajoy do? First, his decision to reject the Commission's proposed deficit target for next year is absolutely correct The Commission's proposed target, which would have implied reducing the deficit by fully 4% of GDP, was absurd. The Commission, especially Commissioner Rehn and Eurozone Finance Minister Chairman Juncker, has got every single major economic policy decision of the last two years wrong; their single-minded focus on austerity in the face of recession has made a bad situation much, much worse. It is shameful that they should now demand the Spanish government should dig the country into a deeper hole.

Two weeks ago, Mr Juncker said: “I am concerned by the high level of unemployment in Spain and increased poverty...but we agreed tonight that Spain would stick to the target.” This is the same man who only a year ago was “very optimistic” about the Greek austerity programme, and had “no reason to doubt” Greece’s ability to pay its debts. As Einstein reportedly said, “Insanity is doing the same thing over and over again and expecting different results.”

If Spain does stick to Mr Juncker’s unrealistic plans, the result will be more unemployment, more poverty, and in the end – as in Greece – the fiscal targets will also be missed as the economy plunges further into recession. Sr Rajoy should stick to his guns, and indeed there is a strong case for him to slow the pace of austerity still further, to make room for growth-enhancing measures.

Instead, Sr Rajoy should concentrate on Spain’s fundamental problems, in particular the dysfunctionality of the labour market. On that he is absolutely right to be radical. But this should not mean levelling down. The privileges of insiders must be reduced, and it must be easier to fire them; but this should be complemented by greater rights for those on temporary contracts. In addition, active labour market policies could help to get young people into work. The example of Scandinavia, Denmark and even the UK show that a flexible labour market and strong productivity growth can go hand in hand with decent , and most of all equitable, employment protection. Radicalism in this area could pay dividends: Spain has a well-educated labour force and plenty of strong companies.

The risk is of course that making the labour market more flexible at a time of recession will lead to more job losses; but this is not a good reason for delaying reform, it merely reinforces the imperative to resist excessive austerity. Spain's long-term fiscal position is still fairly strong, with relatively low overall debt levels; it could afford to go considerably slower. Sensible macroeconomic policy combined with real reform could generate strong job growth, especially among young people, in turn improving the fiscal, economic and social situation.

At the European level, Sr Rajoy should support Prime Ministers Monti and Cameron, who are arguing that austerity alone is not nearly enough to restore growth. As Mr Cameron said in Davos: “This is a problem of trade deficits not just budget deficits... As Mario Monti has suggested, the flip side of austerity in the deficit countries must be action to put the weight of the surplus countries behind the Euro.”

Last summer I argued: “a fiscal consolidation plan that is too aggressive might satisfy the macho instincts of some politicians, but may not be either sensible or deliverable in either political or economic terms.” Earlier this month, Sr Rajoy said: “Now more than ever it is imperative that we distance ourselves from delusional proposals, that we deal with realistic figures, and that we implement policies accordingly.” He is right.

For economists to pretend that they know what the structural balance is, given that the margin for error is gigantic, and that it is based on the absurd NAIRU concept, is just plain arrogant.

NAIRU looks even more absurd when talking about countries with open borders.

The structural balance has also become tied up with things like Ricardian Equivalence, and the ability to repay government debt, which is rubbish for countries like the UK which have no financial constraint.

When I hear the term "structural deficit", I usually just switch off!?

Another point to note about Spain (and for that matter the UK) is that it was probably the fact that their budget deficit was too small in the first place that forced the private domestic sector to become indebted to support growth.

To put it another way, If Spain had not had a property bubble, but tried to keep its small budget deficit, it's GDP growth would have trurned negative, forcing tax reveues to fall, welfare to rise, and the budget deficit to increase anyway.

"For economists to pretend that they know what the structural balance is, given that the margin for error is gigantic, and that it is based on the absurd NAIRU concept, is just plain arrogant."

You may have seen these comments?"The distinction between automatic and discretionary fiscal policy, and hence between cyclical and structural deficits, is a political distinction, not an economic one." I fear, then, that the idea of a structural deficit serves a political rather than analytical function. It's a pseudo-scientific concept which serves to legitimate what is in fact a pure judgment call - that borrowing needs cutting. By all means, make this call. Just don't think that talk of a structural deficit helps enlighten us." http://www.investorschronicle.co.uk/Columnists/ChrisDillow/article/20100215/1b8f8020-1a1e-11df-b0bd-0015171400aa/The-myth-of-the-structural-deficit.jsp